Role of Derivatives in Creating Mortgage Crisis

How Derivatives Could Trigger Another Financial Crisis

The real cause of the 2008 financial crisis was the proliferation of unregulated derivatives in the last decade. These are complicated financial products that derive their value by reference to an underlying asset or index. A good example of a derivative is a mortgage-backed security.

How Derivatives Work

Most derivatives start with a real asset. Here's how they work, using a mortgage-backed security as an example.

A bank lends money to a homebuyer.

The bank then sells the mortgage to Fannie Mae. This gives the bank more funds to make new loans.

Fannie Mae resells the mortgage in a package of other mortgages on the secondary market. This is a mortgage-backed security, which has a value that is derived by the value of the mortgages in the bundle.

Often the MBS is bought by a hedge fund, which then slices out a portion of the MBS, let's say the second and third years of the interest-only loans, which is riskier since it is farther out, but also provides a higher interest payment. It uses sophisticated computer programs to figure out all this complexity. It then combines it with similar risk levels of other MBS and resells just that portion, called a tranche, to other hedge funds.

All goes well until housing prices decline or interest rates reset and the mortgages start to default.

Role of Derivatives in Financial Crisis

That's what happened between 2004 and 2006 when the Federal Reserve started raising the fed funds rate. Many of the borrowers had interest-only loans, which are a type of adjustable-rate mortgage. Unlike a conventional loan, the interest rates rise along with the fed funds rate. When the Fed started raising rates, these mortgage-holders found they could no longer afford the payments. This happened at the same time that the interest rates reset, usually after three years.

As interest rates rose, demand for housing fell, and so did home prices. These mortgage-holders found they couldn't make the payments or sell the house, so they defaulted. For more, see Subprime Mortgage Crisis Timeline.

Most important, some parts of the MBS were worthless, but no one could figure out which parts. Since no one really understood what was in the MBS, no one knew what the true value of the MBS actually was. This uncertainty led to a shut-down of the secondary market, which now meant that the banks and hedge funds had lots of derivatives that were both declining in value and that they couldn't sell.

Soon, banks stopped lending to each other altogether, because they were afraid of receiving more defaulting derivatives as collateral. When this happened, they started hoarding cash to pay for their day-to-day operations. For more, see 2007 financial crisis timeline.

That is what prompted the bank bailout bill. It was originally designed to get these derivatives off of the books of banks so they can start making loans again.

It is not just mortgages that provide the underlying value for derivatives. Other types of loans and assets can, too. For example, if the underlying value is corporate debt, credit card debt or auto loans, then the derivative is called a collateralized debt obligations. A type of CDO is asset-backed commercial paper, which is debt that is due within a year. If it is insurance for debt, the derivative is called a credit default swap.

Not only is this market extremely complicated and difficult to value, it is unregulated by the Securities and Exchange Commission. That means that there are no rules or oversights to help instill trust in the market participants. When one went bankrupt, like Lehman Brothers did, it started a panic among hedge funds and banks that the world's governments are still trying to fully resolve.